Friday, February 25, 2011

Exporting Speculative Debt

You know that information has officially entered the mainstream financial world when the Wall Street Journal writes about it. George Melloan recently wrote an article entitled "The Federal Reserve is Causing Turmoil Abroad", in which he stated that the tsunami of debt-dollars unleashed via quantitative easing over the last year has caused food and energy prices to skyrocket in countries around the world. This price inflation has, in turn, chewed through the disposable incomes of those with the least income to spare, which is now a majority of the population in many countries, and has led to social and political unrest/revolution.

However, he did not use the term "debt-dollars" and, in fact, he did not even refer to debt in the article. So while it is comforting to know that some people in the mainstream financial world are finally starting to connect a few crucial dots, it it still true that these people are missing the bigger picture those dots comprise. The
Federal Reserve has indeed printed money and helped drive up commodity prices throughout the global economy, but none of this price inflation is achieved without its trusty sidekicks, the major investment banks (hedge funds), and their weapon of choice, leverage.

This dynamic represents the tail end of one that has existed for several decades, where financial consumers in both developed and developing economies had artificially increased demand for dollar-denominated commodities such as crude oil, wheat and corn. While most of these consumers no longer have access to any credit and are struggling to pay off debts, the major banks have virtually unlimited access to free credit from central banks. This credit is used to speculate on stocks, bonds and commodities for short-term profits, just as it had been previously used to speculate on real estate. In this sense, the Fed is not "exporting inflation" as the WSJ article argues, it is exporting speculative debt.

Some may argue that this distinction is a technical one, and that inflation is all too real for those Egyptians or Tunisians who have had to struggle with rising food/energy prices that they can barely afford. This argument simultaneously contains and misses the fact that these people are only struggling with high prices because there have been no corresponding increases in their incomes and revenues, or decreases in their obligations. That fact exposes the true nature of the exported "inflation" in these countries - it's all speculative sizzle and no steak. The American people have to look no further than their own real estate market to see where this trend is headed.

Zero Hedge reports that total margin debt used by hedge funds to purchase equities peaked at $290B in January 2011, while total free cash is at its lowest level since July 2007 [1], and it would be safe to assume that a similar dynamic exists in the commodities sector as well. Investors have been using pure leverage to speculate on asset prices, rather than debt-free cash, and this process, like any other pyramid scheme, is always self-limiting. When prices do not cooperatively continue their exponential escalation to infinity, we can expect all of those margin calls to force a panicked sell-off across all asset classes.

While it is impossible to predict exactly when such an event will occur, it is almost a near certainty that it will. Dr. Steve Keen, a notable Australian economist, has even gone so far as to dynamically model this financial process. His model demonstrates how speculative financial investment in a pure credit economy will inevitably lead to a severe recession/depression once the speculative debt levels overwhelm the productive capacity of the economy. [2]. Despite what they would like us to believe, central banks such as the Fed are not immune to this dynamic and there will soon come a time when quantitative easing is politically impossible and/or financially impotent.

Already, the Fed's "QE Lite" program of monetizing mortgage-backed securities and agency debt has dramatically slowed down as rates have started to climb. Excess reserved held by the investment banks with the Fed increased by $73B in the past week, which means that the risk mentality is subsiding and less money is being used for speculation. Sales of new single-family homes shot down almost 13% last month, and 2010 Q4 GDP was "unexpectedly" revised all the way down to 2.8% from 3.2%. [3], [4]. As economic data continues to disappoint, leveraged speculation will become increasingly anathema to American investment banks sucking at the teet of the Fed.

The connection between the Fed, commodity price increases and social turmoil may have entered the mainstream dialogue, but it is exactly when the mainstream recognizes a financial trend that it soon reverses. Investors amassed on one side of a trade will be forced to quickly shift to the other side, and the "inflation" exported by the Fed will be revealed to be just another speculative romp crafted for the benefit of those who made out like bandits during the last one. As The Automatic Earth has repeatedly stressed, however, a deflationary price collapse will make necessary commodities even less affordable for the average person, due to a dramatic reduction in private revenues and public benefits. So while the superficial financial trend may change, the social turmoil will continue on, and next time Egypt's revolution may not be so "peaceful".